Value investors make money by finding companies that are undervalued based on the state of their business today. Their capabilities typically become undervalued because of bad management, a temporary misstep in judgment or a cyclical downturn. Any of these factors will usually trigger an excessively negative emotional reaction by the market–creating the buying opportunity.

Growth investors like me, on the other hand, are dreamers. We try to find companies that will likely be expanding their profits at a faster rate than the market expects, and for a longer time than the market expects.

Where the value investor asks “What can go wrong in the here and now from this point on?” and answers “Nothing that the market hasn’t already discounted three times over,” the growth investor asks “What can go right over the next few years that market is unwilling to pay for today?”

A generation ago, the classic growth stock was Wal-Mart (WMT), a company that built superstores on the outskirts of small towns with under 250,000 population and prospered by taking market share away from inefficient mom and pop local merchants. It started in Arkansas and grew…and grew…and grew, for a long as there were new small towns to attack.

In this generation, we might think of Apple (AAPL) or Google (GOOG). In the former case, it was the ability of a highly skilled management to resuscitate the brand and produce the iPod and then the iPhone that the market didn’t understand when the stock was at $25. With GOOG, it’s the power of search that was vastly underestimated.

If a stock is going to reach, say, $100 a share–the growth investor’s dream–whether we pay $10 or $12 or $20 isn’t the crucial decision. Getting on the train at some early stop is all that matters.

Selling at the appropriate point, however, is much more crucial.

How so?

what goes up…

Let’s say the market expects that a certain company is going to grow profits at 15% per year for at least the next several years. The next quarterly earnings report comes in at +20% in profit growth; management says it thinks it can continue to grow at the higher rate.

Two positive things typically happen:

–the stock rises to adjust for the higher reported earnings, and

–the price earnings multiple expands, as the market begins to factor in the idea that the firm can grow more quickly than it thought. In other words, the price rises more than simply the good earnings report would justify.

Let’s say that the quarter after that, earnings come in at +25%–and that management continues to make bullish comments about its future.

For a true growth stock, a WMT or an AAPL or a GOOG, this process of upward adjustment can go on for years.

At some point, though,

…must come down

…the stock market gets tired of being wrong on the downside. It makes an emotional swing to the upside that can’t possibly be justified by the company’s fundamentals …ever.

Typically, this is expressed as a sky-high price earnings multiple.

In addition, in my experience, the life span of a typical shooting star earnings grower is about five years. After that, earnings growth begins to slow. The crazy multiple expansion comes toward the tail end of the super growth period.

As the market senses that slower growth is in the offing, the process of upward adjustment goes into reverse. The stock declines to reflect weaker than anticipated earnings, and the price earnings multiple begins to contract.

This is usually a very ugly process, with the stock declining much more than one might ordinarily expect.

The trick for a growth investor is to exit the stock, at least in large part if not totally, before this happens.